Marriot Corporation-Cost of Capital

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Marriot Corporation: Cost of Capital

By Xue Fan

Background
Marriott Corporation began in 1927 with J. Willard Marriott’s root beer stand. Over the next 60 years, the business grew into one of the leading companies in industry in United States. In 1987, Marriott’s sales grew by 24% and its return on equity stood at 22%. Sales and earnings per share had doubled over the previous 4 years, and the company strategy was aimed at continuing this trend. Marriot Corporation had three major lines of business, which are lodging, contract services, and restaurants. Lodging operation included 361 hotels with more than 100,000 rooms in total. Hotels ranged from the full-service, high-quality Marriott hotels and suites to the moderately priced Fairfield Inn. Contract services provided food and services management to health-care and educational institutions and corporations. It also provided airline catering and airline services through its Marriot In-Flite Services and Host International operations. Restaurants division included Bob’s Big Boy, Roy Rogers, and Hot Shoppes. In term of revenue, contract services was the biggest division which generated 46% of 1987 sales, and lodging division came after with 41% sales, restaurants division at last with 13% sales. In April 1988, Dan Cohrs, the vice president of project finance at Marriott Corporation, was preparing his annual recommendations for the discount rates at each of the firm’s three divisions. Since the risk profile were different for each division, Cohrs projected three different discount rates, which were 10% for lodging division, 15% for restaurant division, and 16% for contract services division.

Company’s goal
As mentioned in Marriott’s 1987 annual report, the company intended to remain its premier growth. This means aggressively developing appropriate opportunities within its three lines of business. And in each of these areas, Marriott’s goal was to be the preferred employer, the preferred provider, and the most profitable company. Marriott had four key elements of financial strategies, which were manage rather than own hotel assets; invest in projects that increase shareholder value; optimize the use of debt I the capital structure; repurchase undervalued shares.

Financial strategies of Marriott
1. Manage rather than own hotel assets
In 1987, Marriott developed more than $1 billion worth of hotel properties, making it one of the ten largest commercial real estate developers in the United States. After the development, the company sold the hotel assets to limited partners, while retaining operating control as the general partner under a long-term management contract. While under long-term management contract, management fee basically equaled 3% of revenues plus 20% of the profit before depreciation and debt service. The 3% of revenue usually covered the overhead cost of managing the hotel and the 20% of profit went to investors and partners before managers actually got paid. During the year of 1987, Marriott operated about $7 billion worth of syndicated hotels. By syndication and selling assets to partners, Marriott managed rather than own hotel assets. And instead of put hotel assets on balance sheet to depreciate, Marriott could maintain a higher income growth. 2. Invest in projects that increase shareholder value

In order to decide which project to invest in, the company used discounted cash flow techniques to evaluate the net present value. Good investments with high NPV will definitely increase shareholders’ wealth. But the problem was the accuracy of assumptions the company used to determine discount rate. In this case, the specific discount rate for a project was based on market interest rates, project risk, and estimates of risk premiums and that discount rate may vary due to any change in theses dimensions. In short run, investing in projects needs initial investments, which may reduce the asset of a company needed to support its growth. In...
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